The Laffer Curve is a simple idea: a government can’t raise taxes forever and expect to increase revenue along the way. Eventually you’re taking so much in taxes that people don’t have any reason to earn income. The argument is simple (and correct): if you have zero tax rate you get zero tax revenue. If you raise taxes just a bit, nobody will be discouraged from working, and you will collect some amount of revenue; therefore, the curve of revenue versus tax rate starts at zero and initially rises. But if the tax rate is 100%, nobody has any reason to work, and your total revenues will be back at zero. By the wonders of math, there must therefore be a maximum of the curve somewhere in between 0% and 100% tax rate.
An important question is, where are we on the curve? The notion of the Laffer curve has been used to justify all sorts of tax cuts, under the assumption/claim that we are to the right of the maximum, so that cutting taxes will actually increase revenues. Serious economists generally don’t believe this holds true in the U.S. right now, but the lure of the idea is undeniable: lose weight by eating more ice cream!
Via Marginal Revolution, here’s a study by Mathias Trabandt and Harald Uhlig that tries to get it right. Obviously they have models that make various assumptions, and I have no idea how realistic those assumptions are. They study the U.S. and several European countries, and find that Denmark and Sweden are just a bit on the wrong side of the curve for the specific case of capital income taxation. For the most part, however, tax rates lie to the left of the maximum. In the U.S., especially, we are significantly on the left. Here is the graph for labor taxes:
The vertical line is our average tax rate; the curves represent different model assumptions. They estimate the U.S. could increase revenues by about 36% by raising taxes. That obviously doesn’t necessarily imply that we should — but we could.
Obviously Sean has no clue that Mathias Trabandt and Harald Uhlig have no clue what they are talking about. (Findings based on assumption are not scientific… they are conjecture.) Is it too much to ask that our stories not be contingent only upon supposition?
It’s funny how conservatives cannot bring themselves to believe that liberals have rational reasons for believing that government-funded services have their place in a well-ordered and free civil society. We must all have been brainwashed by some invisible bogeyman to which they are somehow immune.
Face it, John Ramsden, Brits love having the BBC and their National Health Service, and woe betide any government that seeks to do away with them (not that any would dare).
As for Suetonius’s barely comprehensible rant. Maybe you should try visiting Denmark and find out for youself how they live, breathe, and yes, think for themselves. East Germany it is not, and never will be. As for American freedoms, why not ask the millions of incarcerated American citizens (more than 10 times as many, per capita, than Denmark — ten times!) how much freer they feel living in America.
It is amazing that anyone takes the Laffer Curve seriously anymore. It should have been left on the cocktail napkin in that bar. The idea that anyone can chart out a graph when its ends are undefinable is silly. I can recurve it and shift it left and right to say anything I want, and not a single economist can dispute me.
Pure junk.
Sean
When you say that no one has a reason to work, does that mean they choose to starve to death or die of exposure?
Just out of curiosity, where does all that revenue go anyway? Into a big hole?
Suetonius’ ravings cite the Carter years as an example of how bad things were when tax rates were higher. In so doing he demonstrates his historical illiteracy and lack of critical thinking skills. Why? 1)The economy wasn’t in the toilet then because of high marginal tax rates, but because of other factors;
2) Marginal rates had been far higher before, and the economy was pretty good – the early 1960s comes to mind, when the top marginal rate was **91 percent**.
I’m sure that Sean gives away 60% of his income to worthy causes. After tax I mean.
Too bad about the Jaguar.
A few points to make. 1. The average tax rate is irrelevant because people have widely different tax rates. If some people are to the right of the curve but the average is to the left, then revenues could be increased by lowering those top rates. 2. If you include Federal, State, Local, Social Security, and Sales or Capital Gains taxes, the average rate is much higher. 3. There is a different maximum point for different people. The rate that maximizes your taxes may be 80% and mine may be 25%. Further the revenue maximizing rate for high income individuals is probably lower than the rate for low income individuals (who can’t afford to stop working). 4. While the economy may have been fine when marginal rates were higher, the increase in income inequality helps to prove the Laffer Curve. When tax rates on high income individuals was reduced, their incomes (before taxes) increased at a faster rate.
We know for a fact that taxes could be much higher and that this would lead to much higher revenues and much higher economic growth, at least in the United States. We had 90% marginal tax rates in the 1950s through the 1970s and we had much higher growth rates, and much more tax revenue, than we have now. We just have a lot of unpatriotic people who benefit greatly from our system who don’t like paying for what they get.
Suetonius: I don’t make nearly enough working as an academic scientist to fall into the highest tax bracket. Since you are so bent out of shape about taxes, I’m guessing that you do?
As a matter of fact, I am “taxed” at 56% by my university when I apply for grants. This amount is called “overhead” or “indirect costs” and is supposed to cover things like electricity, building maintenance, grant administrators, etc. So if I need $50k/year to pay a couple of graduate research assistants, I actually have to ask for $50k * 1.56 = $78k. This has a direct effect on my chances of being funded, both because my institution may have higher overhead rates than others and because the extra amount comes out of the total available for the program I am applying to, reducing the number of grants that can be made. Do I mind? Not too much, as long as the money seems to be spent reasonably. It’s only when the university tries to ask me to pay for, eg., electricity directly out of grant funds that I push back, since it should be covered by overhead.
You express a lot of disgust for people who argue that taxes should be set at a level that allows for the adequate delivery of government services. Let me assure you that the disgust is mutual. When I was growing up, I was taught to clear my plates after dinner, clean up my room, etc. — boring things for a kid, but contributing to the overall work load of the household. Those of you who bitch and moan about every cent of taxes and every government program must not have been raised that way. I suppose I should feel sorry for you instead, but I guess that’s _my_ character flaw.
Paul, your “tax rate” would actually be 28/78 = 36%, not 56%.
As for the 100% bound being zero, that stems from the assumption of rationality. Obviously the real world is more complex, so it’s not quite that simple. But it does seem to indicate that we could stand to increase taxes quite a bit. That shouldn’t be surprising considering that the last time we had a balanced budget, the taxes were much higher.
I’d also like to mention that with a progressive tax, the curve is likely to be substantially different for different income brackets.
The Laffer curve is incredibly complex, as is the US tax code. This chart does not reflect the true tax on GDP, federal tax, state tax, SDI, FICA, coorperate tax, sales tax, property tax, the double tax of inheritance and business tax, or medical costs. Many of these are not in this chart. Another huge factor in the laffer curve is the debt level of society, which in the US is at an all time high. There is no single number for the laffer curve, to pretend so is to misrepresent the theory. The true number varies by country by laws and tax structure, and by the current events within that country so that it changes constantly.
The US rate including medical costs is well north of 50%.
And with the current private debt structure any increase will kill the so called recovery.
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There are some obvious fallacies in both the curve presented and in many of the comments. First of all the “U. S. Average” tax line is gee whiz meaningless factoid. The reason is simple, that 95% of the tax revenue paid to the IRS is paid by less than 5% of the tax payers. Because of this the only group that has a significant impact on tax revenues is this 5%, not the “U. S. Average”. If the top 5% significantly shift if and how they generate dollars for themselves they can significantly change how much tax they pay. They don’t have to quit making money. They, by virtue of their wealth have more options than the rest of us and they can and will use those options to their own best self interest, no matter what silly restrictive laws are written by the socialists. If that 5% change their financial activity in a way that has a major reduction in their tax liability they can (in theory) take their contribution to tax revenue to near zero which would effectively reduce tax revenues to the IRS to near zero, regardless of what the other 95% of income earners do.
One more comment regarding the tripe about people liking what they do so they would do it regardless. That is more in tune with hobbies than jobs. However, this to is easily demonstrated as a bunch of feel good bunk. In order to understand this it only requires superimposing the political ideologies onto the curve that are associated with higher and lower taxes. That is freedom and liberty on the left side (0% tax rate) and Marxist socialism on the right side. As a practical matter and as demonstrated by history the only way to get to the 100% tax (government ownership of all labor and property) is by way of a totalitarian state. This type of government is not characterized by a tolerance for people doing their own thing, i.e. doing what you love to do. In all of the cases I can think of where a government owns all the property and labor, which is what a 100% tax nation is, there is no free choice as to what vocation a person does. They are told what they will do to benefit the government the most. This is decided by some government official who is far removed from the individual and has no interest in what the individual wants. This is where the utopians theory always breaks down – when it meets the harsh realities of actual implementation.
On the other end of the spectrum is zero tax thus no government, just complete freedom and liberty. Of course the argument against that is that it leads to anarchy. Although the preachers of crisis and fear who say that freedom is to dangerous to be given to the common man are overstating their case it seems plausible that some government is necessary, which brings us back to the discussions taking place during that long summer when the U. S. Constitution was written. None of the arguments being presented had anything to do with “how much can we tax the people to get the most out of them”. Taxation was a means to an end, and end which we collectively have lost sight of. The States created the Federal government, via the U. S. Constitution, and gave it certain powers (Article I, Section 8) to provide basic security for the states so that all other matters may be attended to within each State.
The Laffer Curve is an interesting exercise that demonstrates the fallacy of the tax and spend mindset but it was probably never intended to be the center of discussion about how much tax should be levied in a nation such as the united States of America, a nation that is unique among all others in its founding principles. To focus on how much can we tax to get the most money misses the point. The real point is what is the proper activity of the Federal Government and how can that be done most efficiently so as to reduce the taxes to a minimum that a free and sovereign people will allow to be levied upon themselves in order to secure the natural rights they were given before the founding of this nation.
” The highest combined tax rate is in Denmark. Interestingly, the party which has been in power for years is a liberal party in the sense that such parties traditionally favour a minimal state.
And yet Denmark often comes tops when polling the happiness, optimism, and entrepreneurial spirit of its citizens, especially its young people, who don’t see at all phased by the high tax burden.”
Why the “yet”? One could just as well, or even better, say: BECAUSE OF THIS, Denmark often comes tops…
“But then, when you don’t have a single moment’s worry about how you are going to pay for your health care, or about being made destitute by one wrong turn in your life, then I guess you’re free to dream the dream. That’s what conservatives don’t seem to get.”
Indeed.
“The higher taxes become, the more an economy is degraded and corrupted long term as politicians have more money to fritter away on idealistic unworkable misguided schemes (and intrusive and totalitarian ones), bribing voters with welfare and health spending, and hampering private enterprise.”
Interesting that Norway, Sweden, Denmark and Finland—all countries which have had high taxes for decades—always come out on top in Transparency International’s list of the least corrupt countries.
Saab, Volvo, IKEA, ABBA, ABB, Ericsson, Marabou,… not bad for a country of about 8 million people. Doesn’t look like the high taxes stifled private enterprise. Yes, Volvo and Saab are not what they once were—at least the automobile divisions of these companies (they have others). That’s because US automakers now own those automobile divisions.
Even if the graph shows that the US could charge higher taxes, it would be political suicide for any lawmaker to suggest a thing. It would also hurt the economy, which is based mainly on consumer spending, to take money away from the consumer and place it in the pocket of the government. The reduction in consumer spending that would result would mean a loss of jobs which would then result in a loss of income and payroll tax revenue as well as a loss of other tax revenues as the newly unemployed stop consuming, which would lead to even further job loss and reduce consumption even further. Raising taxes will only increase revenue in a society that does not depend so heavily on the consumer having plenty of discretionary income to spend.
“Interestingly, the party which has been in power for years is a liberal party in the sense that such parties traditionally favour a minimal state.”
Can you please tell me where you got this information, because here in the US the Democrats (liberals) are the party of big government and maximum interference in the lives of the people. It is the Republicans (conservatives) that want to shrink government and remove it from the lives of the people to the extent that it is possible to do so.
“Even if the graph shows that the US could charge higher taxes, it would be political suicide for any lawmaker to suggest a thing. It would also hurt the economy, which is based mainly on consumer spending, to take money away from the consumer and place it in the pocket of the government.”
Of course, the government spends the money it gets. Some countries have 30% of the population working in the civil service. So, your statement is a non sequitur.
““Interestingly, the party which has been in power for years is a liberal party in the sense that such parties traditionally favour a minimal state.”
Can you please tell me where you got this information, because here in the US the Democrats (liberals) are the party of big government and maximum interference in the lives of the people. It is the Republicans (conservatives) that want to shrink government and remove it from the lives of the people to the extent that it is possible to do so.”
[Big sigh]
Time to explain some terms. Yes, your definitions apply in the States. Note that one really needs two dimensions to describe political parties: left and right, liberal and conservative aren’t enough. One axis is “individual freedom vs. state-defined morals” and the other is “free-market economy vs. more state control of the economy”. In the US, with the two-party system (only slightly better than a one-party system, but I digress), you don’t see the full picture. Look at a typical European country, Germany for example. Grossly simplified: The Social Democrats are for personal freedom and for state control of the economy. The Christian democrats are for the state defining how people should behave and for free-market economy. The Free Democrats (roughly corresponding to the Liberal Democrats in England) are for personal freedom and for free-market economy. (The fourth combination: the state controls the economy and, as far as it can, your thoughts, is typical of dictatorships.) It varies from country to country, and from time to time within a country, which aspect of “freedom” the Free Democrats emphasise. (“Liberal”, in a European context, usually applies to such parties.) The Danish Liberal party (which for historical reasons is called “Venster”, “Left”, though this doesn’t refer to a left-wing party today, but rather the name comes from when left-wing meant “opposed to the monarchy” and conservative was in support of the monarchy; the name has stuck and the party gets along fine with the Queen these days) has historically emphasised free-market economics and little government intervention in the economy, in contrast to the Social Democrats and Communists, who hold/held power for a long time in Sweden and Norway.
In the States, the Democrats are called liberals due to their stance on civil rights etc and the Republicans are conservatives because they favour more “traditional family values” etc. So this is just one axis. As far as the other axis goes, the Republicans might be considered more liberal (think free as in free enterprise, not free as in free love) in the European sense, but in practice both are very free-market orientated compared with European parties (in almost no European country would a conservative party question state-run healthcare, for example). (Also on the other axis, personal freedom, both are quite conservative compared to European standards. In some states in the US, certain sexual practices are actually illegal between married heterosexual consenting adults behind closed doors. OK, they might not be enforced, but the laws are still on the books. And other laws which apply when one or more of the five constraints above are dropped ARE enforced; people get ten years in prison for things which in other countries are expected behaviour. But I digress.)
Liberal originally meant free in the sense of freedom from the state, an absolute monarchy being the opposing viewpoint. The meaning then evolved into open for change in the political system, whereas conservative meant “keep things as they are”. (One could add “radical” for those in favour of quick change (etymologically, it means addressing the root of a problem) and “reactionary” for those for whom keeping things as they are isn’t good enough; they want to turn the clock back to the good old days.) Liberal then took on both meanings “personal freedom” and “free enterprise”. However, what if the change you want happens and you want to keep it that way—are you then conservative or liberal? The problem occurs because labels which were appropriate in the past might not be appropriate now. In Russia, communists are often described as conservative or, these days, reactionary, not in the sense of right-wing but in the sense of keeping things as they are (as opposed to moving towards a free-market economy) or, these days, turning the clock back.
Well, the government thinks that it’s their money anyway, after all they created it even if they didn’t earn it.
The future is “gaming the system”.
Everywhere, as here in the US, we have individuals that are experts at it.
If you earned a 4.0 in a course you are only entitled to a 2.5. Just as with income tax, 37.5% will be surrendered to the Internal Scholarship Service, then to be redistributed to the Officially Sad.
No, wait! According to Cosmic Variance social activism, 60% confiscation is optimum. You earn a 4.0, you get a 1.6, and only the deserving graduate magna cum laude. Fair is fair.
Couldn’t help but pass along an old (two years) blog post from Brad DeLong concerning the lengths the Wall Street Journal Editorial Page will go to keep the Laffer Curve alive. This should serve as an exercise in how to NOT do curve fitting.
http://delong.typepad.com/sdj/2007/07/most-dishonest-.html